Typically S corporations save their shareholder-employees significant amounts of payroll taxes. But because of the California Subchapter S franchise tax, California-based small businesses need to ask and then carefully answer the question, “Do California S corporations Save Taxes?”
In this short post, I want to explain how S corporations save their owners payroll taxes. Then I want to explain how the California S corporation franchise tax works. Finally, I want to provide some rules of thumb readers can use to think about the option of running their California small business as an S corporation.
S Corporation Tax Savings: A Quick Review
S corporations don’t change the income taxes a business owner pays. If you run a business that makes, say, $100,000, you will pay the same amount of income tax regardless of whether you operate the venture as a sole proprietorship, partnership or S corporation.
However, running your business as an S corporation can change the payroll taxes your firm pays for its shareholder-employees. So let me explain how this works…
Note: Operating a business as a C corporation can result in a different, usually higher income tax bill. But that’s a special subject and not one I’m covering here. If you’re interested, you can skim a longer article available at my S Corporations Explained website, “Does a C Corporation Save the Successful Business Owner Tax?”
The combined Social Security and Medicare tax runs roughly 15% on the first $120,000 of earnings a small business owner makes. If a sole proprietor makes $120,000, she will pay roughly $18,000 in self-employment taxes. If a partner in a small partnership makes $120,000 as his share of the firm’s profits, he will pay roughly $18,000 in self-employment taxes.
However, if either of these business owners owns their business interest through an S corporation, only the part of the business profits specifically called out as shareholder-employee wages gets subjected to the 15% tax.
A sole proprietor who incorporates her business will need to, after incorporation, pay herself payroll. But if she pays herself $60,000 of the profit as wages and then $60,000 as a shareholder distribution, only that first $60,000 of wages gets hit with the roughly 15% payroll tax. That means only about $9000 of payroll taxes are paid—and not $18,000.
A partner who contributes his partnership interest to an S corporation will need to, after incorporation, pay himself payroll. But if he pays out $60,000 of the partnership profit share as wages and then $60,000 as a shareholder distribution, again, only that first $60,000 gets hit with the payroll taxes. This nearly cuts the payroll tax bill in half. Which is great.
Note: The payroll tax calculations work a little more complicated than I describe here. The actual tax rate is not 15% but rather 15.3%. The 15.3% rate apples not to $120,000 exactly but to an inflation adjusted amount, currently $118,500 in 2016. Finally, half the payroll taxes paid count as an income tax deduction and as a deduction for payroll taxes. You can however think about them as working in the simplified manner I describe here as long as you know we’re being a little rough.
What Happens When Income Rises Above $120,000-ish
The 15%-ish rate, I should point out, applies only up to about $120,000.
Once business income rises above that level, a business owner either pays a 2.9% Medicare tax or a 3.8% combined Medicare and Obamacare tax. When the 3.8% tax rate kicks in depends on what else appears on your tax return, but if you’re single you can assume the tax kicks in once your income crosses the $200,000 threshold and if you’re married you can assume the tax kicks in once your income crosses the $250,000 threshold.
What this means, and this is probably obvious, is that you save lots of money with an S corporation when you can avoid the 15%-ish tax… but not as much when you avoid only that 2.9% or 3.8% tax.
And once you understand this stuff, you’re ready to think about how California’s S corporation franchise tax impacts your decision to run your business as an S corporation.
How California’s Franchise Tax Works
California complicates the S corporation decision for small businesses because it levies a 1.5% excise tax on business profits.
In the case where a business owner makes $120,000 and splits this into $60,000 of wages and $60,000 of leftover profits, California levies that 1.5% tax on the second $60,000. That adds $900 to the business owner’s tax returns and eats up a chunk of the S corporation tax savings.
Note: We’ve got a longer discussion about how California’s S corporation franchise works in the “relevant related links” shown at the end of this post.
Don’t Forget About California State Payroll Taxes
California also levies additional employment taxes on S corporations and shareholders, including state unemployment taxes, state disability insurance, and employer training taxes.
A small corporation can exclude a shareholder from the state disability insurance (as discussed in more detail here in the paragraphs about California.) But even so, the state unemployment taxes and training taxes add about $500 in taxes for each shareholder-employee.
Making Sense of the California S Corporation Situation
What does all this mean? Well, you should work out the numbers for your specific situation. But I would say this: If you’re using an S corporation only to avoid the 15%-ish payroll tax, you can typically generate enough savings to more than pay for that 1.5% S corporation franchise tax as well as the maybe $500 per shareholder-employee state unemployment and training tax. This is the case, you hopefully recall, when your S corp makes $120,000 or less.
If you need to pay your shareholders a higher compensation amount than the Social Security tax threshold, which means you’re only saving the Medicare tax rate or the combined Medicare and Obamacare taxes, you can maybe still save taxes. But the margins get pretty thin. In these sorts of situations, you often need to be making a lot of money to make it worthwhile to go to the work of setting up and operating an S corporation.
You are not, for example, going to save much if you avoid a 2.9% Medicare tax but then have to pay a 1.5% California franchise tax as well as maybe $500 in state payment taxes for each shareholder-employee.
Finally, the situation looks a little bit better if you’re talking about avoiding the 3.8% Medicare and Obamacare tax… This occurs when shareholder incomes are somewhere over that $200,000 to $250,000 threshold. Saving a 2.3% chunk in taxes (the 3.8% Medicare tax minus the 1.5% California S corporation franchise tax) doesn’t seem like a lot. But this amount adds up if you’re saving it on hundreds of thousands or millions of dollars of income.
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